The High Cost of Low Price

Should free market advocates oppose a plan aimed at lowering prescription drug costs? Generally, no. But, when such a plan involves the flexing of federal government muscle and threatens future health care, the answer changes. Those are the stakes in the current debate over whether Medicare should have authority to directly negotiate prices for its prescription drug program. <?xml:namespace prefix = o ns = “urn:schemas-microsoft-com:office:office” />


Under the current system, prices for drugs covered by Medicare's Part D program are negotiated by insurance companies and pharmacy benefit managers (PBMs) that operate Part D plans. Advocates of direct negotiation argue that the current system doesn't produce the lowest possible prices. Medicare's vast enrollment, they argue, would grant government negotiators sufficient clout to get a “better deal.” To no one's surprise, the House of Representatives has voted to grant Medicare this authority. However, before the Senate rushes to agree, everyone should reflect on whether coercively-produced lower prices are really a “better deal” for ailing Americans.


There is little doubt that coercive government power could lower drug prices, creating some short-term accounting savings. The question is whether those “savings” today might not worsen health care tomorrow. Driving down drug costs might push pharmaceutical sector revenues below the rates of return needed to justify continued investment. And reducing investments in a world where medical progress is both important and costly means a slower rate of medical progress. Are lower prices of this sort really a good thing?


It is true, as many point out, that the Veterans Administration (VA) already negotiates its prices and enjoys substantial price discounts. However, these discounts in part reflect the fact that the VA buys in bulk which does lower marketing costs. In contrast, Medicare merely pays the bills while the individual enrollee makes the purchase. Medicare's involvement doesn't reduce marketing costs by much. Moreover, the VA's savings stem less from its effective bargaining than from its political power. The VA drove down prices in part by threatening to deny firms access to the Medicaid and Medicare programs.


But, in the real world, any industry wishing to continue operations must find some way of covering its total costs. If the VA is to pay less, someone must pay more. That problem is not very serious as long as these coercive powers are granted only to the VA, a rather small component of the total drug market. In contrast, Medicare covers a much larger fraction of the US population which would make it much harder to cover costs elsewhere. And while it remains true that the House legislation does not grant Medicare the power to coerce pharmaceutical firms as does the VA, taking this first step increases the likelihood that such additional powers would be granted in due course.


Thus, the basic question remains: Are lower prices obtained in this way (rather than via efficiency gains or regulatory relief) really in the public interest? Pharmaceutical firms like many other sectors of our modern economy are characterized by what economists call “declining costs” (the costs of production fall as total production levels increase). Consider that a drug company may spend several hundred million dollars producing the first pill but incur minimal costs in producing subsequent units. The high introductory prices for the product reflect the huge investment needed for research and development, not only for that drug but for the many other drugs that fail to make it out of the lab.


For industries of this sort, setting price equal to production costs is crazy. The firm would cover none of its overhead costs, none of the costs of research, development or testing. Thus, while a firm may well charge such marginal costs to some customers, it will charge others much more. In practice, firms often vary the prices widely to match the diversity of their customer base. Unfortunately, such diversity pricing is often attacked as “discriminatory” – how dare a firm sell a life-enhancing pill for a dollar when it costs pennies to produce? Of course, this challenge confronts every industry characterized by declining per unit costs. Firms in this situation can always sell a few items at the lower prices (everyone can handle a few VA situations) but they can remain in business only if they are also able to sell a reasonable fraction of their output at much higher prices. In such industries, it is not easy for everyone to fly tourist class!


The pharmaceutical industry has long operated as other declining cost industries, seeking creative ways of marketing its products so as to serve the widest population, while still raising enough revenues to ensure a healthy rate of return. PBM purchasers may pay somewhat lower prices on one drug, somewhat higher on others. The pricing and marketing of such products is highly complex and not readily understood by outside observers. But it should be clear that any attempt to simply thwart current pricing and marketing practices would be a disaster.


Moreover, it is far from clear that granting Medicare direct negotiation powers would produce significantly lower costs. Yes, Medicare is a massive program and would presumably have major purchasing power. However, the three largest PBMs that now dominate much of the drug purchasing world already handle the needs of some 200 million Americans. True, the 42 million Medicare beneficiaries spend somewhat more than do most Americans on medical care, but certainly these PBMs possess considerable market clout. Why should anyone assume that Medicare bureaucrats would do better?


The one asset that Medicare might uniquely exercise would be the political power already exercised by the VA. As noted, the current legislation soft-pedals this feature but the threat remains. Does anyone really believe that a Congress eager to promise a champagne health care system at beer budget prices would long allow any drug maker to defy Medicare's demands for lower prices? Does anyone believe that Congress would be passive if Medicare beneficiaries lost access to drugs that might represent their best treatment option? The more likely option would be for Medicare to make an offer they couldn't refuse: Sell to Medicare at bargain basement prices or sell to no one at all!


This push, therefore, for granting Medicare negotiation powers is really a push for imposing pricing controls on the drug sector. In time – possibly a very brief time – the result would be to transform today's innovative pharmaceutical sector into another regulated utility. And the last century has amply demonstrated that regulated utilities are far less innovative than the economy as a whole. And America – faced with the growing significance of the diseases of aging, the emergence of new diseases around the world, and the fact that many important ailments still lack any effective intervention – needs more not less medical innovation. Yet, if the Senate follows the House down this road, we can anticipate a drastic reduction in the rate of medical innovation.


Lower prices are often a good thing—but paying a reasonable price for a quality health care future is a much better idea.